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Quantity Theory of Money (QTM)
1. Introduction
📌 The Quantity Theory of Money (QTM) explains the relationship between money supply and price levels in an economy. It states that inflation is caused by excessive money supply growth and that money has a direct effect on prices but not on real economic variables like output or employment.
🚀 Why is it important?
✔ Helps understand inflation, deflation, and monetary policy.
✔ Forms the foundation of classical and monetarist economic theories.
✔ Explains why money supply control is key to stable price levels.
2. The Quantity Equation
📌 The QTM is mathematically expressed as: MV=PYMV = PY
Where:
- MM = Money supply
- VV = Velocity of money (how often money circulates)
- PP = Price level
- YY = Real output (GDP)
📌 Key Assumptions:
✔ Velocity (V) is constant – People spend money at a stable rate.
✔ Output (Y) is fixed in the short run – Determined by labor, capital, and technology.
✔ Any increase in MM leads to an increase in PP, meaning inflation is directly linked to money supply growth.
3. Theoretical Foundations of QTM
🔹 1. Classical View: Money is Neutral
✔ Classical economists (David Hume, Adam Smith) believed money only affects nominal variables (prices, wages) but not real variables (output, employment).
✔ Doubling the money supply doubles prices but does not change real GDP.
🔹 2. Fisher’s Equation of Exchange
✔ Irving Fisher formalized the QTM with: MV=PTM V = P T
✔ TT represents the total transactions in an economy.
🔹 3. Cambridge Cash Balance Approach
✔ The Cambridge economists (Marshall & Pigou) modified the QTM as: M=kPYM = k P Y
Where kk is the fraction of income people hold as money.
✔ This approach emphasizes money as a store of value, not just a medium of exchange.
4. Policy Implications of QTM
🔹 1. Inflation Control
✔ If the central bank prints too much money, inflation rises.
✔ Hyperinflation (e.g., Zimbabwe, Venezuela) occurs when money supply grows too fast.
🔹 2. Role of Monetary Policy
✔ Since money supply determines inflation, central banks should control money growth to maintain stable prices.
✔ Monetarists (e.g., Milton Friedman) argue for a fixed money supply growth rule to prevent inflation.
🔹 3. No Long-Run Trade-Off Between Inflation and Unemployment
✔ According to Milton Friedman and Edmund Phelps, the Phillips Curve breaks down in the long run.
✔ Increasing money supply may lower unemployment temporarily, but in the long run, it only increases inflation.
5. Criticisms of the Quantity Theory of Money
🔸 1. Keynesian Critique
✔ John Maynard Keynes argued that money demand is unstable, and increasing money supply does not always lead to inflation (especially in recessions).
✔ During downturns, people hoard money instead of spending, so prices do not rise.
🔸 2. Variable Velocity of Money
✔ The assumption that velocity (V) is constant is unrealistic.
✔ In financial crises, velocity falls because people save more and spend less.
🔸 3. Short-Run Effects on Output
✔ Modern theories recognize that money affects GDP in the short run before returning to neutrality in the long run.
6. Conclusion
✔ The Quantity Theory of Money links money supply to inflation and supports monetary policy’s role in price stability.
✔ In the long run, money is neutral and affects only prices, not real GDP.
✔ Critics argue that money demand and velocity change over time, making QTM less reliable in the short run.
✔ Today, central banks use controlled money supply growth and inflation targeting to manage economies.